The economy and the stock market are not the same

By LARRY SWEDROE

While stocks began their sharp decline caused by the coronavirus in mid-February 2020, we have only begun to see the damage done to the economy. The first signs came from the weekly new claims for unemployment. Then we saw the April unemployment figure rise almost a full percent in one month to 4.4%. We’re also about to receive a barrage of evidence from regional manufacturing indices, and business and consumer confidence indexes, and a whole host of other indicators. We’ll likely see the sharpest rise in unemployment we have seen since the Great Depression, surpassing perhaps by wide margins the 10 percent figure reached during the global financial crisis. And GNP in the second quarter seems set to fall on an annualized basis by perhaps 30 percent or more.

Knowing that the economic news is going to be very bad, it may seem logical to sell stocks now and wait for the economic news to get better, or at least stop getting worse. History suggests that would be a mistake because the economy and the market are two very different things. The economic news will be backward looking, reporting on what happened. On the other hand, the market is always forward looking, including anticipating that the worse the economic news, the more likely it is that central banks (monetary policy) and governments (fiscal policy) will take countercyclical measures to turn things around.

It’s also important to understand that because the markets are highly efficient at incorporating all known information into current prices, there is a big difference between information and value relevant information. In other words, if you are aware the news is likely to continue to be bad, surely all the large institutional investors that dominate trading and therefore set prices are also aware of the facts. Thus, the scary information that has you worried is already incorporated into prices. In other words, it is not that the stock market has to go lower because of the bad news. Instead, it is that the market is where it is because of the bad news, and if things were not this bad, prices would be higher.

With this understanding we know that it is unexpected events (which by definition are unpredictable) that are the major factor driving future stock prices. Thus, it doesn’t even matter whether future news is good or bad. What matters is whether it is better or worse than already expected.

What can we learn from the global financial crisis?

We know today that the recession caused by the global financial crisis ended in June 2009. However, unemployment did not peak until the end of 2009 at 10%, and it was still at 9.4% at end of 2010. However, from March 2009 through December 2009, the S&P 500 Index returned 54.6%. And it was up another 15.1% in 2010. That’s a total return of almost 78% over the 22-month period. Now ask yourself, if you knew unemployment was going to rise from 8.1% in February 2009 to 10% by December, and still be much higher at 9.4% at the end of 2010, and with the GNP falling 2.4% for the year (that was just the first estimate, with the final estimate being 3.1%), if you thought stocks should have been bought or sold in March 2009, or at any time in between?

Which raises the question of why did the market recover while the economy continued to perform poorly? The reason for the strong performance is that the market expected the economy to do even worse. The fact that while the news was not good, it was still better than expected, fuelled the rally. However, only investors that had the discipline to stay the course benefited from that rally.

Summary

Investors know that risk and expected return are positively correlated. The greater the perceived risk, the higher the expected return must be. Increased perception of risk is what causes bear markets. But the lower valuations (falling P/E ratios) that result also mean that expected returns are higher.

I cannot accurately predict what future returns can be, and neither can anyone else. Thus, the winning strategy is to have a well-thought-out plan, one that anticipates the virtual certainty that you will experience many severe crashes (this is the fourth of at least 37% since 1973) and make sure that your portfolio’s risk does not exceed your tolerance for taking risk. That will help provide the discipline needed to adhere to the plan when risks inevitably show up and the economic news turns bad. And if you cannot resist the temptation to focus on the negative economic news, perhaps this warning from legendary investor Warren Buffett will help. Never try to time the market. But, if you cannot resist the temptation to time the market you are best served by being fearful when others are greedy, and greedy only when others are fearful. To help you stay disciplined, consider the following.

First, the most important sector of our economy, the banks, are in much stronger position than they have ever been in, far stronger than they were going into the great financial crisis. Second, fiscal and monetary policy has been highly aggressive — the “big guns” in the war against the invisible enemy that is the virus are being shot all around the world. And, in terms of fiscal policies, some countries have been even more aggressive than we have relative to the GNP.

What does this all mean for future stock prices? What we do know is that the market is forward looking, and perhaps we have seen the bottom. However, we may not have. We also know that volatility tends to cluster — if today’s volatility is high, it’s likely to be high tomorrow. So, strap yourself in as the ride seems likely to be wild.

What also seems highly likely is that just as the Federal Reserve kept interest rates very low for a very long time after the economy bottomed out and began its recovery, that is likely to be the case now as well as the damage done to the economy will be much larger. It’s possible that we could be living with zero, or near zero, interest rates for years. That means the risk-free rate is very low. We also have seen equity valuations drop sharply. The Shiller CAPE 10 (cyclically-adjusted price-to-earnings ratio) was more than 30 as we entered the year.

The inverse of the CAPE 10 is as good an estimate as we have of future stock returns. The E/P then was projecting a 3.1% real rate of return for US stocks. Add perhaps 2% for estimated inflation and you get an expected nominal return of about 5%. By April 4, the earnings yield was 4.3%, more than a full percent higher. That puts expected nominal returns at 6.3% which, with a one-month T-bill rate of 0.05%, gives us an ex-ante equity risk premium (ERP) of above 6%. While that is not as high as historically has been the case, it looks attractive. Outside the US, valuations are even more attractive because they have underperformed for a decade. International developed markets forecast nominal returns approaching 9% (assuming 2% inflation). For emerging markets the nominal expected return is about 10.5%. Those are large equity risk premiums. However, the risks are also clearly high. There is no free lunch. One such risk is the possibility of a global L-shaped recovery due to the huge debt burdens being taken on by governments all around the world to replace the demand lost due to the lockdowns of economies. Thus, you should never take more risk than you have the ability, willingness, or need to take.